Admitting an employee as a co-owner into your existing business can be a great tool to help grow your business. If done wrong, though, you’ll regret it.
Steve had a successful manufacturing business. He’d put in a lot of time and money to get the business where it was, but was looking to step back and slow down. His right hand man, John, seemed to be the right person to run the business. John, though, wanted a piece of the action.
To accomplish this, Steve transferred some of his stock to John, giving John a 20 percent interest in the business.
Unfortunately, this had a different effect. John decided that, as an owner, he no longer had to put in the long hours he once did. John also thought the business was now his personal slush fund, taking trips, having dinners and doing other things on the business tab. Without Steve and John, there was no one at the helm and the added expenses hit profits hard.
The business faltered, and Steve had to come back into the business to right the ship. When he learned what John was doing (or, rather, not doing) he wanted John out. Unfortunately, John wouldn’t sell his shares back to Steve at anything near a reasonable price. Steve had two bad choices: pay John’s ransom for the shares (he wanted a lot more than 20 percent of the business value for the shares) or let John have 20 percent of the net income and cash from selling the business. Plus, as the business grew and became more valuable, John would get 20 percent of Steve’s effort.
Steve paid the ransom to get rid of John right away.
What should have been done? The only reason to add a partner is to grow the value of your business. And you’ll have to grow it by more than the percentage you’ll give up to the new co-owner so you come out ahead. With that in mind, there are a few issues that must be addressed when you admit an employee as a co-owner.
First, what will the partner pay for the interest in the business? A going concern business has value. (A going concern business has enough assets to function for the foreseeable future without the threat of liquidation.) To be fair for all parties, that value should be determined by an appraisal of the business. Yes, an appraisal is not inexpensive. But it is much less expensive than selling a part of your business for less than fair market value. Would you sell your home without knowing its market value?
Next, there are tax issues that have to be considered from the outset. If you merely transfer that value to an employee, the IRS will treat it as compensation. In other words, it will be as if you gave the employee a cash bonus in the amount of the fair market value of the shares, and then your employee handed it over in exchange for the stock.
That means that income taxes, Medicare and, possibly, FICA will have to be paid. If your business is worth very little, this won’t be a problem. But most going concern businesses have significant value. And the tax problem can be huge.
Let’s say that Steve’s business was worth $500,000. Steve’s transfer of 20 percent of that business means the business effectively paid John a $100,000 bonus (ignoring things like minority ownership discounts). John could have to pay $28,000 out of his pocket just to satisfy the income taxes! And the company would have to withhold and pay its share of FICA, if applicable.
Of course, if John paid $100,000 to the company for his shares, there is no tax problem. Had John paid that amount, he would truly have had “skin in the game” and, perhaps, treated the business differently.
RESTRICTED STOCK GRANT OR STOCK OPTION PLAN
What if John didn’t have the money and Steve wanted to add John as a partner without causing any tax problems? There are two primary ways to accomplish this: the restricted stock grant or stock option plan.
Using a restricted stock grant, John would be issued all of his shares from the company at the time of the grant. But those shares would be lost (the company literally cancels the shares) if John didn’t meet certain conditions, with less shares cancelled as time progressed. Usually the condition is continued employment. So, if John were terminated two years into a four-year employment condition, half the shares would be cancelled.
Now, John would still have to pay income tax. However, his “income” would be less than the fair market value of the shares because he could lose them. And John would have a couple of options on how to treat that income.
With a stock option, John would be granted the right to buy one share of the company’s stock from the company for each option granted, at today’s fair market value (or just a bit higher, depending on John’s position with the company). Assuming all elements of the plan are prepared correctly, the tax code allows the grant of the options without the grant being income to John.
Stock options typically vest (they’re able to be exercised) over four or five years of employment, with no options vesting until one full year has been completed. If John doesn’t perform adequately in the first year, he wouldn’t have had the ability to purchase any stock. And John can hold the options for up to 10 years. He can exercise the options just before the company sells in a “cashless” exercise to get the benefit from the company’s sale without having to invest any cash.
Both options should be accompanied by an appropriate written employment agreement.
Finally, how do you keep the business if John leaves or you want him to leave? What happens if John is fired after a year or two or three, and he’s exercised options or the forfeiture provisions of a restricted stock grant have gone away? This is when the shareholders agreement is required. With a shareholders agreement, the company and the other shareholders can restrict John’s ability to sell the shares and require that he resell them to the company. Furthermore, a shareholders agreement can be structured to prevent John from causing problems by voting his shares or exercising certain rights he has as a shareholder. For example, if Steve wants to sell the company through a stock sale to get the tax benefits, John could refuse to sell his shares. Without a shareholders agreement, there is nothing Steve could do.
Other similar situations exist.
By considering all of the issues involved in admitting an employee as a co-owner and preparing appropriate written documentation, the company can grow and become more profitable without the downside risk.